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I can start withdrawing from my 401(k) in 30 years. I'm currently in one of the the highest federal tax brackets and will likely be in the lowest tax brackets when I start withdrawing. That alone might indicate that I should avoid taxes now (to the extend that the contributions allow me to) and pay them in retirement (i.e., choose pre-tax 401(k)). However, Roth 401(k) also renders earnings tax-free.

Assuming I contribute $10,000 today, I expect to have on the order of ~$10,000 * 1.1^30 ~= $170,000 in 30 years (assuming 100% equity and past returns). If I choose Roth 401(k) instead of pre-tax 401(k), suppose my taxes increase around 10% on my contributions/basis because I earn less in retirement compared to now. I lose 0.1*$10,000 = $1,000 from this. However, I don't pay any taxes on earnings ~$170,000-$10,000 = $160,000, which clearly dominates the ending 401(k) balance and any reasonable tax rate on earnings should favor Roth 401(k).

Am I misinterpreting what constitutes "earnings" or is this a no-brainer?

(I'm assuming that tax rates remain roughly unchanged for 30 years, but even if they increase, it should favor Roth 401(k) even further.)

EDIT:

Some people suggested some other threads that are interesting, but not narrow enough for my particular (previous) confusion. In particular, I was specifically concerned about untaxed gains. The top answer clarifies this specific uncertainty.

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  • 2
    It seems like you're assuming a 10% annual return on your investments. Is that realistic?
    – Teepeemm
    Mar 11 at 16:27
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    @nanoman so funny how you linked to a question where the top comment is also you saying the same thing and linking to a different question xD
    – cjnash
    Mar 11 at 19:19
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    See my comment on Craig W's answer. The way I would put it is that you're comparing tax dollars today with tax dollars 30 years from now. Tax savings today have the advantage that those savings can be invested at the assumed 10% return for 30 years!
    – nanoman
    Mar 12 at 3:33
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You say you're in one of the highest federal tax brackets now, but your math assumes a 10% tax rate now, and an unspecified rate in retirement. Using realistic numbers let's say you're in the 35% bracket now, and when you retire you'll withdraw into the 24% bracket.

pre-tax: $10,000 x 1.1 ^ 30 = $175,000 x (100% - 24%) = $133,000

Roth: $10,000 x (100% - 35%) = $6500 x 1.1 ^ 30 = $113,000

Pre-tax comes out ahead, which you'd expect because multiplication is commutative. It doesn't matter if the tax is taken out up front or on the back end if the rate is the same. To a first approximation, if you expect your tax rate is higher now than in retirement, use a pre-tax 401(k). If you expect your tax rate is lower now than in retirement, use a Roth 401(k). The big caveat is this assumes tax rates stay the same between now and retirement, but it's not a bad approximation.

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    @RobertHarvey Not an oversimplification (unless you get into considerations like required minimum distributions). When the tax happens is irrelevant, only the rate. Do the math above with the same tax rate, and you'll see the final value is equivalent.
    – Craig W
    Mar 11 at 17:16
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    "if you expect your tax rate is higher now than in retirement, use a pre-tax 401(k). If you expect your tax rate is lower now than in retirement, use a Roth 401(k)." +1 It really is this simple. (caveat: nonlinear utility of money, you could argue for traditional as a hedge possible futures where you aren't well off, even if the expected tax burden was higher on average)
    – John K
    Mar 11 at 18:21
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    You dont have to pick one or the other. The tax rate analysis should be performed for each marginal dollar you contribute and each marginal dollar you expect to withdraw in retirement. Although you are absolutely correct for a "first approximation"
    – Matt
    Mar 11 at 19:41
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    @reffu You are correct. I think the way I did the comparison was the fairest, but if you're going to contribute the same percent of your paycheck either way, that would certainly tip the balance toward Roth.
    – Craig W
    Mar 11 at 21:53
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    "your math assumes a 10% tax rate now, and an unspecified rate in retirement" -- I disagree that this was assumed. OP writes, "If I choose Roth 401(k) instead of pre-tax 401(k), suppose my taxes increase around 10% on my contributions/basis because I earn less in retirement compared to now." That is saying the tax rate in retirement will be 10 percentage points lower than the tax rate now. OP then says the tax difference on the contributions seems outweighed by the tax difference on the earnings. And what OP was missing is simply that with traditional, you invest your tax savings.
    – nanoman
    Mar 12 at 3:18
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To address the issue with your numbers as specifically as possible: Suppose you're in the 32% bracket now, and in the 22% bracket in retirement. This fits your statement:

[with Roth] my taxes increase around 10% on my contributions/basis because I earn less in retirement compared to now

Now, to make a $10k Roth 401(k) contribution, the story starts with $14,706 of your gross wages that you can spare. After paying the 32% tax on that, $4,706, you have $10k to contribute. Great! And you never pay tax on that investment again.

On the other hand, if you make a $10k pre-tax contribution, you don't pay tax today on the $10k you contribute, but you do pay 32% tax on the remaining $4,706 in wages; the tax is $1,506, leaving you $3,200 in disposable cash.

In both cases, the 401(k) balance grows to $174k over 30 years. For pre-tax, you pay 22% tax on withdrawals in retirement. So if you picture some $10k out of the $174k as your contribution, you will pay $2,200 tax on it. Thus, per your calculation, you appear to have a net savings of $3,200 - $2,200 = $1,000 on that $10k.

That $1,000 net savings sounds pretty small, as you note. However, the key question is: What did you do with the $3,200 in extra up-front cash that you got by contributing pre-tax? Did you just stuff it under your mattress? Why not put it in the 401(k)? In fact, you can increase your pre-tax contribution not just by $3,200, but by $4,706! That is, you can contribute the full $14,706 of gross wages that we assumed you could spare in the first place.

The extra $4,706, growing at 10% for 30 years, becomes $82k. Now we're talking! So instead of a $174k tax-free balance in the Roth, when withdrawing from pre-tax you pay 22% tax, but on a much bigger balance of $174k + $82k = $256k. And that leaves you $200k to spend, which is more than you would have with the Roth.

This demonstrates that pre-tax is favored in your scenario where your tax rate is 10 percentage points lower in retirement.

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  • This conclusion works for op, but does it break down if you’re at/around contribution limits? If so, I’d suggest pointing out that caveat so future readers aren’t tempted to extrapolate to their own circumstances
    – thehole
    Mar 13 at 0:38
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Yes, your analysis is correct, but a fairer comparison would be to keep the out-of-pocket outlay the same, i.e. compare

  • contributing 10k to your Roth, nondeductible, to be 10k out of pocket this year, and withdrawing 10k * growth factor in retirement
  • contributing 10k / (1 - marginal tax rate today) to your traditional, and deducting it, to be 10k out of pocket this year, and withdrawing 10k / (1 - marginal tax rate today) * growth rate * (1 - marginal tax rate on withdrawal) in retirement

Thus, for the same out-of-pocket outlay, if your marginal tax rate today is 35% and on withdrawal is 10%, then you'd prefer to contribute your out-of-pocket outlay to the traditional. If the other way around, you'd prefer the Roth.

A corollary is that if you're planning to contribute the full 19.5k contribution limit, you'd always prefer the Roth: a traditional contribution equivalent to a 19.5k Roth contribution would be to the tune of 19.5k / (1 - marginal tax rate today), which would exceed the legal limit unless your marginal tax rate today happens to be zero.

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Another factor to consider when trying to compare Roth vs Traditional 401K plans is that they have different minimum withdrawal requirements, both for age and required withdrawal amounts. Depending on your financial needs, one might be more advantageous to you than the other for your own "big picture" of retirement savings. Yes, total savings is important, but also how you anticipate using those savings is also something that needs to be considered.

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Those numbers are fun, but miss the point

we can do the interest-vs-taxes calculations, and it's interesting and it seems like an answer, but it overlooks a number of very important characteristics.

It assumes withdrawals will be evenly divided. WRONG.

All these calculation models assume you'll be able to withdraw the traditional IRA at an even, uniform rate from age 59-1/2 to death. That's important to keep the tax bracket lower than it was in your working years, which the whole concept rests on. Too bad life doesn't work that way!

The first fatal flaw is you don't know how long you'll live, so you can't distribute the payouts evenly over your retirement.

Next is the practical reality of late life in the US. I have witnessed many people have series of health crises in the last 10 years of their life. They wanted or needed better care than Medicare would provide - everything from "donut hole" pharmaceuticals to home care or assisted living residency. Some were pulling $10,000 or more a month out of their 401(K)s.

Suddenly they're up in a 32% bracket, paying through the nose and having to withdraw even more 401(K) money to pay the tax bill, pushing next year's bracket higher still.

Now admittedly this tends to happen in the very last years of life, when the person can laugh and say "Haha, IRS can't touch me in the grave" -- but that's not actually what happens. Real world, the elderly person is put in tremendous stress by all this. It actually hurts their health and recovery.

After I saw what was happening to these retirees, I started converting all my 401Ks to Roths.

Not just health, either.

Alternately, you may have high-value investments you want to make, such as buying into a retirement condo community, buying the grandchildren a house, making an investment not available inside the 401(K)'s limited options, giving a bequest to a charity, etc. Any of these large distributions will also cause a "bolles" of tax slam with a traditional. This will make you think twice about doing it, which takes some of your freedom away.

Bottom line, you actually get mauled on taxes, and the idea "tax brackets will be lower in retirement" is pure fantasy.

With a Roth, that is simply not a problem. You can withdraw the money at any rate needed without tax or penalty.

You must also wrestle with mandatory distributions

With traditional IRA and 401(K), you have mandatory distributions- starting at 70-1/2 you must take some of the money. IRS does not want to wait forever to collect those taxes. Many people are still active at 70-1/2 and some may be collecting real income. So these mandatory distributions will push up your tax bracket whether you need them right now, or not.

Again, traditional's cause loss-of-control of your money and taxes.

And if you're not on the ball, you can find yourself having failed to do those distributions, and then you have tax complications and penalties.

Roth has no mandatory distributions. It just does what it says on the tin, sit there and wait for you to spend it.

Roth has a much higher contribution limit. Really.

Because of compounding, you are much better off eating ramen, using a flip phone, and donating the absolute max contributions in your earliest years. Better to max for the first 5 years and 0 in the next 5, rather than half-max all 10 years.

If you want to max out your contributions early, to enjoy the maximum growth... Roth lets you contribute a great deal more money. Because the contribution limits are the same, but the Roth money is already taxed. Try it! Go back to those calculations everyone's lovin', but set it at contrib max.

Al contributes $19,500, the max for a traditional 401(K). Let's say this grows 17x... to $331,500. Then, Al withdraws it over the years, in a 20% bracket, losing $66,300 to taxes, netting $265,200 of real money.

Bob earns $25,000 then pays 22% tax ($5500) on it. This nets out to $19,500, which is the max contribution to Bob's Roth 401(K). It grows the same 17%, also to $331,500. Then, Bob withdraws it all and has $331,500.

How did Bob get 25% more money into the 401K? Bob contributed $25,000 of pre-tax dollars, but Al contributed only $19,500. Bob contributed 28% more money. (and got bit a tiny bit worse on taxes, being in a 22% bracket instead of 20%).

I'm "making up" the 20% bracket because we don't know what taxes will be when you retire.

Just a reminder: we're not talking about total money. Obviously, since Al is able to put less money into the 401(K), Al has more money outside the 401(K). The fate of that money is beyond this discussion.

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  • How did Bob get $25k? To be fair, you have to let Al start with $25k of earnings too. After the traditional contribution, Al pays taxes on the remaining $5.5k and is left with $4.3k. In your accounting, Al's $4.3k seems to have just disappeared. Al can put it in taxable (tax-efficient) investments. It will grow to $73k, and after 15% long-term tax on the gain, Al will have $63k. Adding that to the $265k gives $328k, almost as much as Bob. And if Al ends up avoiding capital gains tax (e.g., by charitable donation or inheritance step-up), he gets $338k.
    – nanoman
    Mar 13 at 4:44
  • @nanoman The world in which Al is such a disciplined and impeccable investor is also the world in which ones death date is known and one never has surge expenses in retirement. In the real world, that $4.3k does disappear. Mar 13 at 16:24
  • Counting 0% of taxable savings seems much more wrong than counting 100%. Al can make an after-tax 401(k) contribution of $4.3k if he's worried about having the discipline to leave it untouched until retirement. (That doesn't take any more money or discipline than Bob has.) Even if Al can't do an in-plan Roth conversion, he will have $73k with the gain taxable at 20%, leaving $59k. Adding that to the $265k gives $324k. So only $4k less than I estimated for a taxable account and only $8k less than Bob. You claimed Al has $66k less than Bob.
    – nanoman
    Mar 14 at 7:52
  • Your argument leads to the absurd conclusion that Al (or anyone) shouldn't even bother trying to earn additional money, because none of it will be saved, and it will just get him used to a higher lifestyle and make it harder to retire! You do have some other good points about Roth 401(k) advantages, but I maintain that your Al-Bob comparison is unfair. You can't simply have somebody throw money away to make your point. If you can do that, you can come to any conclusion you want in any situation.
    – nanoman
    Mar 14 at 7:53
  • "Al can make an after-tax contribution of $4.5k" there's the logic problem right there. No, contrib limits are hard limits.. Al could do an NDIRA, but so could Bob so that's a wash. As far as the rest, that is not what I said. I have tuned my answer to clarify exactly what I said. Wasn't much of an edit. As far as my comment, I withdraw it. It's tangential to my point, admittedly arguable, and I'm not here to argue that. Mar 14 at 16:21

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